| In the process of China's reform and opening, there are a number of divergences between the RMB exchange rate and the domestic price. What causes the twin sides of the monetary value on the opposite road? How the divergent affect the monetary authority's policy and its implementation? In order to solve the doubt, it is necessary to research the long-term relationship between the RMB exchange rate and the domestic price. However, when the author attempts to explore the relationship in context of the RMB exchange rate regime reforming, but found the relationship between current RMB exchange rate and domestic price is only an appearance. The intrinsic link between RMB exchange rate misalignment and changes in price levels is the deep-seated reasons. This link appears to be the contemporary existence of exchange rate devaluation (or overvaluation) and inflation (or deflation). To chose the relationship between RMB exchange rate misalignment and changes in price levels to be the research object, it is not only helpful for revealing the deep-seated reasons but also for making more effective policy recommendations. Based on this consideration, this paper makes a study along the following context.This paper is divided into seven chapters, chapter I give introduction of the research background, significance, research status and the methods.Chapter II reviews the equilibrium exchange rate and exchange rate misalignment theory and measurement methods such as the purchasing power parity theory, the fundamental equilibrium exchange rate theory, behavioral equilibrium exchange rate theory etc. through comparative analysis, we selected BEER to be the methods.Chapter III following the need of BEER model we select six fundamentals such as labor productivity to be explanatory variables, and construct a theoretical equation of RMB behavioral equilibrium exchange rate, using cointegration analysis based on yearly data of 1980-2009 data and quarterly data 1994-2009, we get the equation of Behavioral Equilibrium Exchange Rate of RMB and calculate the Equilibrium Exchange Rate and Misalignment level. The estimates results based on yearly data and quarterly data show that the trend of equilibrium exchange rate and exchange rate misalignment is very similar during the period of 1994 to 2009.Based on the results of yearly data from 1980 to 1994, the RMB exchange rate misalignment is higher. From 1980 to1982, real effective exchange rate of RMB is undervalued, overvalued the next three years and undervalued during 1986 to 1994.The estimated results based on quarterly data show that there is an overall upward trend of long-term equilibrium exchange rate of RMB lies in that the ratio of Chinese per-capita GDP relative to the world per-capita GDP makes a rapid rise. The RMB REER sometimes devalued and other times overvalued, but its trend is consistent with the EREER, means that there is no serious misalignment.Chapter IV we reviews the process of the RMB exchange rate regime reform and China's price level changes. Before 1994, foreign exchange management system reform, the RMB exchange rate was rigid, and deviated from China economic conditions. Since 1994, the market degree of the RMB exchange rate gradually increased, exchange rate movements and foreign economic had more influence on our domestic economy. As the higher China's economy openning degree, changes in external demand did more effects on China's price level from exchange rate pass-through. Since the 1978 reform and opening up, China has experienced many times of inflation, respectively, in 1980, 1984~1989, 1993~1995, from 2003~ 2008. In 1998 to 2002, China has also appeared deflation. Since 2008 subprime mortgage crisis, China's price index continued to decline, deflation once again.Chapter V we give the theoretical analysis of the impact that exchange rate misalignment make to domestic prices based on pass-through theory.Chapter VI we make emprical analysis of the exchange rate misalignment effects on domestic prices. We find there is corresponding relations between the two variables during sample period. That an undervalued exchange rate via inflation, overvalued exchange rate via deflation. Granger causality test results show that exchange rate misalignment is the Granger cause of the price changes, in turn, price changes is not a Granger cause of exchange rate misalignment. Exchange rate misalignment and the price changes was the reverse in China. The real effective exchange rate pass-through based on VAR model show that the real effective exchange rate pass-through on domestic prices is negative and decreasing along the price chain, pass-through on import prices is the highest, the second one is that on producer price and the lowest one is that on consumer prices. There are lags of pass-through. For import price it is 5 quarters, industrial producer prices and consumer prices are 6 quarters. The variance decomposition results in the VAR model show that exchange rate changes impact on prices is weak corresponding to other variables. Further, results based on the nonlinear threshold error correction model show that there is non-linear cointegration between the real effective exchange rate and consumer price index.Chapter VII provide some corresponding policy recommendations according to the analysis results. Firstly, there is no serious misalignment of real effective exchange rate, recently, the RMB exchange rate is only 3.59% undervalued so that the monetary authorities have no need to change the level of RMB exchange rate. They should seize the current opportunity to deepen the exchange rate system reform. Secondly, China should adjust export-oriented economic development strategy, reduce the degree of external dependence, switch the driving force of economic growth more towards domestic consumption. Finally, strengthen the capital flows monitoring, and control hot money flow, eliminate the non-rational expectations of RMB appreciation. In particular, handle well the relationship between the RMB appreciation and inflation control.
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